Monday, October 12, 2015

How A Strong Greenback Affects the Economy

The US dollar was reigning supreme in global foreign exchange markets, with 16 major currencies having declined by an average of almost 11% against the greenback since the beginning of 2014. Over that period, the performances of the most widely traded currencies against the dollar were as follows: euro -17.4%, Canadian dollar -14.2%, Australian dollar -10.8%, Japanese yen -10.7%, and British pound -8.4%. As a result, the US Dollar Index, which measures the value of the dollar against the currencies of six major trading partners, rose to its highest in over 11 years in early 2015.

The fact that the dollar's relentless advance has an effect on the US economy is indisputable, but is the overall impact positive or negative? This debate was brought to the forefront when a number of US companies cautioned about the impact of the strong dollar on their earnings in January 2015. Here is a breakdown of how US dollar appreciation affects various aspects of the economy:

Consumers

Consumer spending accounts for approximately 70% of the US economy, and a stronger dollar is a net benefit for this prime driver of the economy. It makes imports cheaper, so everything from noodles to luxury automobiles should cost less. A European luxury sedan that cost $70,000 when each euro fetched 1.40 dollars should cost $57,500 if the dollar subsequently appreciated and the euro was now worth only 1.15 dollars. The stronger dollar also makes US exports more expensive, so a surfeit of domestically-produced goods should translate into lower prices as well.

Cheaper consumer goods would result in more disposable income for Americans, and thus more money to spend on fun things like shopping, eating out, entertainment, and vacations. Specific sectors of the economy that would benefit from this spending spree include retailers, restaurants, casinos, travel companies, airlines, and cruise lines. Stronger domestic demand also helps lessen the detrimental impact of a strong dollar on the US tourism industry, as the number of overseas visitors declines significantly because the higher greenback makes it more expensive to travel to the US and vacation there.

The effect of the stronger dollar on industry is mixed. For instance, most global commodities are priced in US dollars, so a stronger greenback may reduce overseas demand and thus affect revenues and profitability of US resource producers. Manufacturing companies are hit especially hard by the rising dollar, as they have to compete in a global market and a domestic currency that is even 5% stronger can have a considerable impact on their competitiveness.

On the other hand, an appreciating dollar benefits companies that import a great deal of machinery and equipment, like engineering and industrial companies, since these would now cost less in dollar terms.

The stronger dollar gives the biggest advantage to companies that import most of their goods but sell domestically, since their top-line and bottom-line benefit from robust domestic demand and lower input costs.

Conversely, sales and earnings for numerous US multinationals that sell their products and services globally would be affected by the stronger dollar. Pharmaceuticals and technology are two sectors where US firms have a major presence around the world, so they are substantially affected by a rising greenback.

In January 2015, some of the biggest US companies such as Microsoft Corp. (MSFT), Procter & Gamble Co. (PG), E.I. Du Pont De Nemours & Co (DD), Pfizer Inc. (PFE) and Bristol-Myers Squibb Co. (BMY) said that foreign-exchange rate fluctuations (i.e., the strong dollar) would reduce sales – by as much as 5 percentage points in some instances – and also have a negative impact on earnings. However, companies like Apple Inc. (AAPL) (which gets more than half its revenue from outside the US) and Honeywell International Inc. (HON) were able to mitigate most of the effect of the stronger dollar through timely currency hedges.

Currency gyrations have the biggest impact on international trade, making imports cheaper and exports more expensive. Over time, a stronger US dollar will serve to widen the trade deficit, which will gradually exert downward pressure on the greenback and pull it lower.

In terms of capital flows, a stronger dollar may have little impact on foreign direct investment (FDI) into the US, which has long been one of the world's top investment destinations. International companies invested $236 billion in the US in 2013, a 35% increase from 2012, making it the largest recipient of FDI that year. FDI tends to be long-life investments that last for decades, and foreign companies who are attracted by the dynamism and huge potential of the US market may be willing to take the stronger greenback in stride.

The stronger dollar also makes it cheaper for US companies to invest overseas, either in physical assets or foreign entities, leading to higher capital outflows. Cross-border mergers and acquisition activity by US companies may rise during a period of dollar strength, especially if it occurs when US capital and equity markets are near all-time highs (since American firms can use their high stock prices as currency for acquisitions), as was the case in early 2015.

Foreign portfolio investment (FPI) into the US may also increase during a period of dollar strength, as it generally coincides with a robust US economic expansion. An appreciating dollar would boost returns from US investments, an attractive proposition for international investors.

The effect of a stronger dollar on financial markets is also mixed. Perhaps the most direct impact of a rising greenback is its adverse impact on corporate earnings. This was a major reason why the S&P 500 had its biggest decline in a year in January 2015.

As noted earlier, the prospect of investment returns being boosted by an appreciating currency also increases the allure of US Treasuries (and other fixed-income instruments) to overseas investors, as long as the risk of higher interest rates is not significant. Such overseas demand is a factor in keeping long-term US interest rates low, which in turn helps stimulate the economy. Note that a stronger dollar also keeps a lid on "imported" inflation, which makes the case for a rate hike by the Federal Reserve less compelling.

An area of the global economy where the stronger dollar can wreak havoc is in emerging markets. Occasionally, a steadily rising greenback can cause emerging market currencies to plunge on concern about these nations' current account deficits and economic prospects. Plunging currencies greatly increase the dollar-denominated liabilities of emerging market governments and companies, creating a downward spiral that is hard to stop. This can sometimes result in a full-blown disaster like the Asian Financial Crisis of 1997. In an increasingly interconnected global economy, the risk of the surging dollar sparking a crisis in some part of the world that triggers financial market contagion cannot be underestimated or ignored.